IRS Issues New Final and Temporary Regulations on Outbound Reorganizations

TAX CLINIC

by
Michael W. Granberg, CPA, Oak Brook, Ill.

Published September 01, 2013

Editor: Frank J. O’Connell Jr., CPA, Esq.

Corporations & Shareholders

The IRS recently issued temporary and final regulations addressing certain outbound transfers of property, indirect stock transfers, and certain outbound asset reorganizations. Specifically, T.D. 9614, generally effective for transfers occurring on or after April 18, 2013, provides guidance on the requirements to qualify for the exceptions to Sec. 367(a)(5). T.D. 9615, applicable to transactions occurring on or after March 18, 2013, primarily makes changes to the coordination rule applicable to asset transfers and indirect stock transfers for certain outbound asset reorganizations.

Background

Treasury issued proposed regulations in 2008 under Secs. 367, 1248, and 6038B addressing outbound transfers of property under Sec. 361 and certain distributions of a foreign corporation’s stock by a domestic corporation. T.D. 9614 contains final regulations that adopt most of the 2008 proposed regulations with some modifications. The final regulations generally apply to Sec. 367(a)(5), which provides that Secs. 367(a)(2) and (3) do not apply to certain transactions described in Sec. 361(a) or (b). However, subject to the conditions provided in the regulations described below, Secs. 367(a)(2) and (3) can apply if the transferor corporation is controlled (within the meaning of Sec. 368(c)) by five or fewer domestic corporations. For purposes of this determination, all members of the same affiliated group under Sec. 1504 are treated as one corporation.

To understand the relevance of Sec. 367(a)(5) and its regulations, it is helpful to review Secs. 367(a)(1)–(3). If a U.S. person transfers property to a foreign corporation in a transaction described in Sec. 332, 351, 354, 356, or 361, Sec. 367(a)(1) provides that the foreign corporation should not be treated as a corporation for purposes of calculating any gain that should be recognized on the transfer. In effect, unless there is an exception, the impact of Sec. 367(a)(1) is to treat an otherwise tax-free exchange as a taxable transaction. Secs. 367(a)(2) and (3) are two exceptions whereby paragraph (1) does not apply. Specifically, Secs. 367(a)(2) and (3) are applicable to, respectively, (1) transfers of certain stock or securities of a foreign corporation that is a party to the exchange or a party to the reorganization and (2) transfers of certain property used in the active conduct of a trade or business. The final regulations contained in T.D. 9614 provide the guidance whereby a transfer of assets by a domestic corporation to a foreign corporation might qualify for tax-free treatment under one of the exceptions in Secs. 367(a)(2) and (3).

Modifications to the Proposed Regulations

The 2008 proposed regulations provided certain conditions under which a U.S. transferor would be allowed to apply the exceptions in Secs. 367(a)(2) and (3). The U.S. transferor can elect to apply the exceptions as long as any net gain realized by the U.S. transferor is either (1) recognized currently or (2) preserved in the basis of the stock received in the reorganization. As noted, the final regulations largely adopt the proposed regulations with some modifications and clarifications as discussed below.

The proposed regulations provided that the calculation of inside gain should take into account liabilities to the extent that payment or satisfaction of those liabilities would result in a tax deduction. In effect, the U.S. transferor is allowed to benefit from liabilities that it has not yet been allowed to claim as a deduction through a reduction in the calculation of the inside gain.

Treasury and the IRS considered several comments suggesting that other attributes, such as net operating losses and credits, should also be taken into account in calculating the inside gain. Alternatively, some comments suggested that the U.S. transferor should be allowed to recognize a portion of the inside gain sufficient to use any tax attribute carryforwards. Treasury and the IRS did not choose to incorporate these comments in the final regulations, commenting that it would substantially increase complexity. Further, they noted that a taxpayer can use those attributes by not electing to apply the exception to Sec. 367(a)(5).

The proposed regulations required that each controlled group member that receives stock in the reorganization must reduce its adjusted basis in the stock received by the amount that its portion of the inside gain exceeds the gain inherent in that stock. The effect of this calculation can result in a conversion of stock in which the shareholder has a built-in loss into stock with a built-in gain.

Some comments suggested that such an adjustment is inappropriate and, alternatively, the final regulations should require that the adjustment to a built-in loss should be calculated similar to a reduction in basis that would increase built-in gain. Treasury and the IRS did not incorporate the comments in the final regulations, noting that the required basis adjustment is consistent with the legislative history of Sec. 367(a)(5). However, the final regulations do clarify that, if the U.S. transferor does not have an inside gain, no stock basis adjustments are required, even if there is a difference between a shareholder’s built-in loss and its share of the inside built-in loss.

The proposed regulations denied the elective exception to the extent that there is a subsequent significant disposition of the property received from the U.S. transferor with a principal purpose of avoiding U.S. tax. Some comments suggested that the disposition rule should conform to the disposition rule relative to gain recognition agreements, which generally requires that gain be recognized if there is a disposition or other triggering event within five tax years after the year of the transfer. Other comments suggested that a separate disposition rule is unnecessary inasmuch as Temp. Regs. Sec. 1.367(a)-2T(c)(1) would deny the exception if there is a retransfer of the property as part of the same transaction. Finally, other comments suggested that the final regulations should include guidance relative to subsequent transfers of the property in nonrecognition transactions.

The final regulations incorporate some of the comments received to better define the application of this provision. Specifically, the final regulations adopt certain aspects of the gain recognition agreement provisions. Thus, the elective exception is denied only if there is a disposition of a significant amount of the property received in the transaction during the 60-month period beginning on the date of the transfer with a principal purpose of avoiding U.S. tax. The final regulations also clarify that property that is transferred in a nontaxable exchange is generally not treated as disposed of for purposes of the disposition rule.

Some commenters suggested that since the underlying purpose of Sec. 367(a)(5) is to preserve the U.S. taxing jurisdiction over corporate-level gain, it should not apply to a regulated investment company, real estate investment trust, or S corporation (collectively, special corporate entities) because those entities are generally not subject to corporate-level tax. Further, there was a suggestion that, at a minimum, special corporate entities should be included in the definition of controlled group member for purposes of the elective exception because any inside gain could be preserved in the stock received and, when recognized, be subject to U.S. tax in the shareholders’ hands.

Treasury and the IRS remain concerned about preserving the U.S. tax jurisdiction over Sec. 367(a) property. In their view, the general rule of Sec. 367(a) applies equally to any U.S. person. Further, in response to comments that special corporate entities should be considered controlled group members for purposes of the elective exception to Sec. 367(a)(5), Treasury and the IRS note that, if a special corporate entity was allowed to be a member of the controlled group, whether the inside gain preserved in the hands of a special corporate entity is ever subject to U.S. corporate tax would depend on the extent of the domestic corporate ownership of the special corporate entity at the time the gain is recognized. The domestic corporate ownership at the time the gain is recognized may decrease or increase from the time the reorganization occurred. As such, the final regulations do not allow special corporate entities to be treated as controlled group members.

While several comments recommended that indirect ownership through partnerships or foreign corporations be taken into account, the final regulations continue to refer to direct ownership for purposes of satisfying the control requirement. Finally, the proposed regulations define Sec. 367(a) property generally as any property other than Sec. 367(d) property. The final regulations clarify that Sec. 367(d) property is property described in Sec. 936(h)(3)(B).

In summary, the final regulations largely adopt the proposed regulations with the most significant modification being the clarification of the disposition rule. Treasury and the IRS otherwise rejected most comments including, most notably, those suggesting that net operating losses and other attributes should be considered in calculating inside gain, and that special corporate entities should be either excluded from Sec. 367(a) or otherwise included in the definition of a member of the controlled group for purposes of Sec. 367(a).

The Coordination Rules

T.D. 9615 included final and temporary regulations primarily under Regs. Sec. 1.367(a)-3 relating to transfers of stock or securities and, more specifically, to the coordination rule between asset transfers and indirect stock transfers. Certain transactions are treated under Sec. 367(a) as indirect transfers of stock or securities to a foreign corporation even though the transactions may not include actual transfers. Such transactions basically include triangular reorganizations, certain asset reorganizations followed by a drop-down of the assets to a controlled corporation, and successive Sec. 351 transactions. Some transactions that are treated as indirect transfers of stock to a foreign corporation can also include a direct transfer of assets to a foreign corporation. In the event that a transaction includes both a deemed indirect transfer of stock or securities to a foreign corporation and a direct transfer of assets, Regs. Sec. 1.367(a)-3(d)(2)(vi) provides coordination rules.

Generally, the coordination rule provides that Sec. 367 is to be applied first to the asset transaction, then to the deemed indirect stock transfer. The coordination rule can result in recognition and reporting of both inside and outside gain. Before the new temporary regulations, there were three exceptions to the coordination rule. The exceptions below eliminated the application of Secs. 367(a) and (d) to the direct transfer of assets.

Exception 1. Sec. 367(a)(5): If a transaction met the following criteria, Sec. 367 would not apply to the direct transfer of assets:

The U.S. target corporation was controlled by five or fewer domestic corporations;

The foreign acquiring corporation transferred assets to a domestic corporation in a controlled asset transfer;

The tax basis in the foreign acquiring corporation’s stock received by the U.S. transferor is adjusted under Sec. 367(a)(5) with respect to the property transferred; and

The basis of the assets in the hands of the acquiring corporation does not exceed their basis in the hands of the U.S. target.

For example, the coordination rules would generally apply to a forward triangular merger described in Secs. 368(a)(1)(A) and (a)(2)(D) where the domestic target corporation is merged into the foreign acquirer and the target shareholders exchange their stock or securities for stock or securities of a foreign parent corporation that controls the foreign acquiring corporation. However, under the Sec. 367(a)(5) exception, if the assets of the domestic target were transferred to a domestic corporation in a controlled asset transfer, Secs. 367(a) and (d) would not apply to the direct asset transfer and would apply, instead, only to the indirect stock transfer.

Exception 2. Indirect domestic stock transfer: The requirements for the second exception are as follows:

The foreign acquiring corporation transferred assets to a domestic corporation in a controlled asset transfer;

After the transaction, the U.S. transferors own less than 50% of the vote and value of the foreign acquiring corporation (i.e., the transfer must meet the requirements of Regs. Secs. 1.367(a)-3(c)(1)(i), (ii), and (iv)); and

The reporting requirements of Regs. Sec. 1.367(a)-3(c)(6) must be met.

Exception 3. Sec. 351 exception: Successive Sec. 351 transfers qualify for an exception when the ultimate transferee is a domestic corporation. However, if the initial transfer is a transfer described in Sec. 361(a) or (b), this exception does not apply. If the tax basis in the assets in the hands of the domestic acquiring corporation exceeds the basis of the assets in the hands of the U.S. target, the exception does not apply.

The 2008 proposed regulations included language that would modify the Sec. 367(a)(5) exception to incorporate provisions of Notice 2008-10, which was issued on Dec. 28, 2007. Notice 2008-10 announced that the Sec. 367(a) exception would be revised to provide that any adjustment to basis required under Sec. 367(a)(5) would be made only to stock of the acquiring foreign corporation received by the domestic corporate shareholders. Further, the notice provided that, to the extent any built-in gain could not be preserved through basis adjustments, the provisions of Secs. 367(a) and (d) should apply.

Elimination of the Sec. 367(a)(5) Exception and Other Modifications

The temporary regulations eliminate the Sec. 367(a)(5) exception noted above. Based on their continued study of transactions that qualified for the Sec. 367(a)(5) exception, Treasury and the IRS became aware of various transactions that had the effect of repatriating earnings and profits of a foreign corporation where the transaction does not require the recognition of gain or a dividend inclusion. The preamble to the regulations notes an example where the foreign acquiring corporation issues stock and property other than qualified property to a domestic controlled corporation. The amount of stock issued by the foreign corporation is sufficient to preserve the built-in gain in the property transferred. As a result, the taxpayer takes a position that the Sec. 367(a)(5) exception applies and that no gain is recognized on the transfer.

The temporary regulations modify the basis comparison rule in the Sec. 351 exception so that it is consistent with the basis comparison rule in the indirect domestic stock transfer exception. That is, any increase in basis that results from gain recognized by the U.S. transferor with respect to such assets in the initial Sec. 351 exchange is not taken into account.

The temporary regulations make conforming modifications to the gain recognition agreement requirements for outbound transfers of stock or securities in Sec. 361 exchanges. The general rule required that any controlled group member that owns 5% or more of the stock of the transferee foreign corporation immediately after the transaction must enter into a gain recognition agreement. The temporary regulations modify the gain recognition agreement requirement such that the 5% ownership is measured by reference to the U.S. transferor’s ownership of the transferee foreign corporation rather than by reference to the ownership of the transferee by the controlled group members.

The temporary regulations also make conforming modifications relating to the branch loss recapture rules. Specifically, the amount of gain to be recognized under the branch loss recapture rules is to be determined before calculating any gain to be recognized under Regs. Sec. 1.367(a)-7.

Finally, a taxpayer was previously deemed to have established reasonable cause if it was not notified within 120 days of IRS acknowledgment of receipt of the request. While the reasonable-cause relief provisions are generally retained, the temporary regulations eliminate the 120-day rule.

In summary, the most significant change included in the temporary regulations is the elimination of the Sec. 367(a)(5) exception. While this could be an effective tool to reorganize recently acquired U.S. target companies, Treasury and the IRS believed that the exception provided an opportunity to repatriate foreign earnings with no gain or income inclusion.